University of Michigan

TARP Consequences: Lending and Risk Taking

Ran Duchin Denis Sosyura

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Motivation

Troubled Asset Relief Program (TARP)

• Stated goals: stimulate lending and increase financial stability

Capital provided under attractive terms, and banks are not required to report its use

• “This is opportunity capital. They didn’t tell me I had to do anything particular with it.” - Chairman of PlainsCapital Bank

• “Make more loans?” “We’re not going to change our business model or our credit policies to accommodate the needs of the public sector”

- Chairman of Whitney National Bank

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Research Questions

1. Did TARP capital infusions stimulate lending?

• Bank liquidity a key factor in lending (e.g., Puri et al 2010)

• Incentives for alternative uses of funds

2. Did the bailout change bank risk taking behavior?

• Moral Hazard (Merton 1977; Flannery 1998)

• Government monitoring and restrictions on incentive pay

3. Did bank governance matter?

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Data

Application-level data on over 25 million mortgages from

the Home Mortgage Disclosure Act Database (2007-2009)

• Borrower income, gender, and demographics

• Property location by U.S. Census tract (area with about 4,000 residents)

• Bank decision on the application

Data on 28 thousand large corporate loans from DealScan• Originating bank, recipient firm, date of origination, and loan characteristics

Housing market data: home vacancies, housing units, home price

index, population, per capital income, and unemployment

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Identification Isolate the effect of TARP on credit supply by controlling for loan demand

For retail loans: study loan originations by TARP recipients vs. nonrecepients before and after TARP injections

• Applications submitted in the same housing market

• Loan applications with similar observable characteristics

• Banks matched on financial condition and performance

For corporate loans: fraction of loans originated by TARP recipients vs. nonrecepients for a given corporate borrower

• Borrower income, gender, and demographics

• Property location by U.S. Census tract (area with about 4,000 residents)

• Bank decision on the application

• Cover 90% of all mortgage lending (Dell’Arricia, Ingan, and Laeven, 2009)

Data on 28 thousand large corporate loans from DealScan• Originating bank and recipient firm

• Loan characteristics, such as amount, origination date, and interest rate

Housing market data (home vacancies, housing units, home price index, population, unemployment, etc.) from federal agencies

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Lending

Dependent variable = indicator equal to 1 if a loan application is approved

Model (1) (2) (3) (4) (5)

After TARP -0.022 -0.034** -0.009 -0.048*** -0.007[1.607] [2.156] [0.915] [2.953] [0.686]

After TARP x TARP recipient 0.015 0.006 0.006 -0.002 0.019[0.993] [0.334] [0.404] [0.150] [1.439]

Bank level controls No No Yes Yes Yes

Loan application controls No No Yes Yes Yes

Housing market controls No No No No Yes

Bank fixed effects Yes Yes Yes Yes Yes

Tract fixed effects No Yes No Yes No

Observations 25,462,180 25,349,530 23,628,030 23,628,030 11,206,070

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Alternative Hypotheses

Unobservable counterfactual

• Collect data on banks that applied for TARP, were approved, but did not receive TARP capital

Different borrower clienteles of TARP recipients

• Focus on application approvals within the same housing market

• No significant difference in loan demand between recipient and nonrecipient banks after TARP

Sample selection

• Matched sample based on size, capital adequacy, asset quality, earnings, liquidity, and sensitivity to market risk

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Credit Rationing and Risk

 After TARP

After TARP x TARP recipient

Observations R-Squared

Loan-to-income ratio rank

1-0.034*** -0.029***

2,552,800 0.247[6.593] [4.366]

20.000 -0.012***

2,596,540 0.218[0.001] [3.910]

30.001 -0.013***

2,530,580 0.232[0.271] [4.471]

4-0.015*** 0.002

2,446,980 0.231[3.033] [0.412]

5-0.018*** -0.002

2,399,280 0.226[3.523] [0.288]

6-0.017*** -0.012*

2,345,080 0.222[3.141] [1.857]

7-0.023*** 0.005

2,319,740 0.212[4.044] [0.783]

8-0.028*** 0.007

2,292,140 0.211[4.619] [0.965]

9-0.042*** 0.025***

2,290,620 0.206[6.637] [3.384]

10-0.089*** 0.091***

2,375,000 0.231[14.199] [12.355]

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Risk of Investment Portfolios

TARP banks increase allocations to investment securities

Most capital goes to equities, MBS, and corporate debt

The combined weight of these assets increased by 10.0%,

displacing Treasury bonds, short-term paper, and cash

equivalents

Using diff-in-diff estimation, the average interest yield on TARP

recipients’ investments increased by 31.5% after the bailout

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Bank Risk

Risk MeasureSt. deviation of ROA

St. deviation of earnings

Capital asset ratio

Z-Score Beta

After TARP 0.002** 0.002** 0.001 -0.147*** 0.105***[2.230] [2.267] [1.436] [9.086] [3.790]

After TARP x 0.002*** 0.002*** 0.017*** -0.221*** 0.147***TARP recipient [2.593] [2.854] [10.298] [4.117] [3.742]

Liquidity 0.470 0.470 0.000 -0.616 -1.002***[1.458] [1.458] [0.003] [0.819] [14.510]

Crisis 0.000*** 0.000*** -0.000*** -0.001*** 0.000[2.810] [2.849] [8.207] [13.766] [0.872]

Size -0.006*** -0.005*** -0.136*** -0.191*** 0.274***[2.896] [2.786] [19.476] [4.793] [3.251]

Bank fixed effects?

Yes Yes Yes Yes Yes

Observations 101,066 101,066 101,313 100,469 6,847R-squared 0.477 0.477 0.862 0.761 0.645

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Economic Interpretation

TARP recipients significantly reduced leverage: capital asset ratio increased from 9.9% before TARP to 10.9% after

However, the reduction in leverage was more than offset by an increase in asset risk in loans and security investments

Net effect: beta of TARP banks increased from 0.80 in 2008 to 1.01 in 2009

Strategy consistent with investing in higher-yield assets, while improving capital ratios monitored by the regulators

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Governance

Governance measures:

• CEO/Chairman duality

• Board expertise

Banks with weaker governance:

• Greater increase in risk taking

• Lower credit origination

Overall, internal governance can act as an internal control

mechanism in the presence of loose federal regulation

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Conclusion

Liquidity shocks have an asymmetric effect on lending

Banks’ strategic response to capital requirements erodes the

efficacy of this mechanism in risk regulation

Moral hazard outweighs government monitoring and institutional restrictions